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Tuesday, January 21, 2014

"Someday This War's Gonna End"

"Someday this war's gonna end."

-- Lt. Colonel Kilgore, Apocalypse Now

Ralph Nelson Elliott, the man whose wave theory is so often discussed in this column, called third waves "a wonder to behold." In the very first article of I penned for 2013 (January 2, 2013), I wrote:

In conclusion, this is not a rally I would look to short any time soon.
There is massive pent-up energy in the charts, and nested third waves
are not to be trifled with. Third waves are the "point of recognition"
for the masses, and tend to be strong trending waves that rarely let up
for very long. Third waves tend to peg indicators at extreme readings
and stay there for much longer than seems reasonable.

Bulls have been experiencing a third wave rally for over a year now and, looking back at the market's behavior, I think we can all agree that Elliott had it right in his description. But despite the wondrous power behind third waves, there is a dark side to them as well.

One of the "jobs" of a third wave is to shift sentiment from bearish to bullish and vice-versa. Folks who've traded for the past decade have now been fortunate enough to live through massive third waves in both directions, in order to experience this firsthand. In 2008, a third wave decline unfolded into October and did its job of shifting sentiment from bullish to bearish -- so much so that by the time the fifth wave rolled around and bottomed in March, lots of folks had decided stocks were headed to zero (or lower). Bears were fat and happy... and complacent. Some were so complacent that they shorted their accounts to oblivion during the subsequent (current) bull market.

Now sentiment has firmly shifted the other direction. Bulls are fat and happy, and bearish talk is quickly laughed away as "impossible," "stupid," or "stupidly impossible, stupid." Investment clubs have even begun to spring up again -- remember those from the 90's? These are groups of folks whose knowledge of equities is generally limited to something they've seen on TV, and whose raison d'etre (French, literally: "raisins exist") is to buy equities because "stocks always go up in the long run!"

To add to the point, I'd like to again borrow quotes from the archives, this time from February 11, 2013 ("Is Bullish the New Bearish?"):

...for the first time in a while, I decided to check out a few random
articles across the web to get a brief pulse on sentiment. Maybe I just
read the wrong articles, but it seemed like just about everything I
read was bearish and looking for a top. As I skimmed through, I got to
wondering: when did it become so popular to be bearish in the midst of a
powerful rally? Is it contrarian to be bullish now?

I think it's wise to consider that this is pretty much how sentiment
behaves in bull markets: they call it "climbing the wall of worry."
There are always a million reasons not to buy and there are a million
reasons why the market will finally top tomorrow... but it just keeps
going up anyway. Bear markets work in reverse -- once everyone is
convinced that every single decline should be bought with both fists,
then we'll keep dropping. Maybe we'll get there when the bearish
voices are the lone nuts in the wilderness again, like they were in
2000 and 2006-2007.

So -- are we there yet?

Personally, what's surprised me most about this rally is the fact that we've yet to see even a good fourth wave correction. Even third waves don't go straight up (or down) forever. Somewhere along the line they lead to fourth wave corrections. However, there is yet no concrete evidence that said correction has begun.

I still feel the charts suggest caution for bulls, since there have been warning signs that a larger top may be close -- but the market is ambiguous at current levels, and that calls for a different trading approach than when the market is clear. The key to remember is that there will be time to get on board once a real correction starts. Just as we had advanced warning a year ago that a big rally was coming, we should have advanced warning when a real decline begins.

For some perspective, let's look at a long-term chart. Below is the Nasdaq Composite (COMPQ), which has now slightly exceeded July 2012's dual-Fib target zone. The current wave can also be counted as nearly complete, but as noted, is still open to interpretation.

The S&P 500 (SPX) notes two potential counts. I'm inclined to give a very marginal near-term edge to the bulls for a trip to 1860-65. However, if SPX sustains trade below 1835, I'd be inclined to think we're headed at least 20 points further south.

In conclusion, the only easy answer here is that the trend is still up, since there have been no key level breaks yet. That said, I'm not entirely comfortable with the easy answer at the moment, since the indicators have flashed warnings that we may be in the neighborhood of a top. Thus I'm left with the conclusion that it's "too close to call" at this exact moment and we'll have to await a bit more in the way of signals before assigning higher probability to a direction. Trade safe.

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